Capital Expenditure (CAPEX)
What is 'Capital Expenditure (CAPEX)'
Capital expenditure, or CapEx, are funds used by a company to acquire, upgrade, and maintain physical assets such as property, industrial buildings, or equipment. CapEx is often used to undertake new projects or investments by the firm. This type of financial outlay is also made by companies to maintain or increase the scope of their operations.
Capital expenditures can include everything from repairing a roof to building, to purchasing a piece of equipment, or building a brand new factory.
CapEx can be found in the cash flow from investing activities in a company's cash flow statement. Some of the most capital intensive industries have the highest levels of capital expenditures including oil exploration and production, telecommunication, manufacturing, and utility industries
The cash flow to capital expenditure ratio, or CF/CapEX ratio, relates to a company's ability to acquire long term assets using free cash flow .
The cash flow to capital expenditures ratio will often fluctuate as businesses go through cycles of large and small capital expenditures. A ratio greater than 1 could mean that the company's operations are generating the cash needed to fund its asset acquisitions. On the other hand, a low ratio may indicate that the company is having issues with cash inflows and, hence, its purchase of capital assets. A company with a ratio less than one may need to borrow money to fund its purchase of capital assets.
CF to CapEx is calculated as:
CF/CapEx = Cash Flow From Operations / Capital Expenditures
Using this formula, Ford Motor Company's CF/CapEx = $14.51 billion/ $7.46 billion = 1.94. Medtronic's CF/CapEx = $6.88 billion/$1.25 billion = 5.49. It is important to note that this is an industry specific ratio, and should only be compared to a ratio derived from another company that has similar CapEx requirements.
Capital expenditure can also be used in calculating free cash flow to equity (FCFE) to a firm with the following formula:
FCFE = Earnings Per Share – (CapEx – Depreciation)(1 – Debt Ratio) - (Change in Net Working Capital)(1 – Debt Ratio)
FCFE = Net Income - Net CapEx - Change in Net Working Capital + New Debt - Debt Repayment
The greater the capital expenditure for a firm, the lower the free cash flow to equity.
Capital expenditures are the funds used to acquire or upgrade a company's fixed assets, such as expenditures towards property, plant, or equipment (PP&E). In the case when a capital expenditure constitutes a major financial decision for a company, the expenditure must be formalized at an annual shareholders meeting or a special meeting of the Board of Directors.
In accounting, a capital expenditure is added to an asset account, thus increasing the asset's basis (the cost or value of an asset adjusted for tax purposes). capex is commonly found on the cash flow statement under "Investment in Plant, Property, and Equipment" or something similar in the Investing subsection. An agile capital expenditure approval process and transparent operation expenditure management are keys to cost containment and optimization.
For tax purposes, capex is a cost that cannot be deducted in the year in which it is paid or incurred and must be capitalized.
Included in capital expenditures are amounts spent on:
- acquiring fixed, and in some cases, intangible assets
- repairing an existing asset so as to improve its useful life
- upgrading an existing asset if it results in a superior fixture
- preparing an asset to be used in business
- restoring property or adapting it to a new or different use
- starting or acquiring a new business
CapEx is included in the Cash Flow Statement section of a company’s three financial statements, but it can also be derived from the income statement and balance sheet in most cases. This guide will provide a formula for how to calculate CapEx.
How to Calculate CAPEX
If you have access to a company’s cash flow statement, then no calculation is necessary and you can simply see the capital expenditures that were made in the Investing Cash Flow section.
Main types of capital expenditures (CAPEX)?
A capital expenditure (CAPEX) is the expenditure of funds or assumption of a liability in order to obtain physical assets that are to be used for productive purposes for at least one year. Depreciation is used to expense the fixed asset over its useful life.
Examples of common types of CAPEX spending include:
Purchase of a Building or Property
A building or property serves a useful purpose for many years and is often purchased using secured debt or a mortgage.
Upgrades to Equipment
In the manufacturing industry and other industries, machinery used to produce goods may become obsolete or simply wear out. Software Upgrades
Large companies spend a great deal of money to maintain current software that serves a useful purpose for many years and are considered CAPEX spending.
Successful technology companies regularly invest in and expand the capabilities of their computer equipment, including servers, laptop and desktop computers, and peripherals.
Some industries make heavy use of vehicles in order to carry out business.
They should be depreciated as CAPEX spending. Costs for leasing vehicles are treated as operational expenses.
The CAPEX Formula
Property, plant, and equipment (PP&E) is tangible items that are expected to be used in more than one period and that are used in production, for rental, or for administration.
The CapEx formula from the income statement and balance sheet is:
This formula is derived from the logic that current period PP&E on the balance sheet is equal to prior period PP&E plus capital expenditures less depreciation.
Important Note: This formula will produce a “net” capital expenditure number, meaning if there are any dispositions of PP&E in the period, they will lower the value of CapEx that is calculated with the formula. To adjust for this, you will be required to read the notes to the financial statements.
The Economy / Gross Domestic Product (GDP)
Investment / Gross Fixed Capital Formation (GFCF)
- In this approach GDP is calculated as the sum of four categories of expenditures on output. These are:
- Gross Private Consumption Expenditures(C)
Gross Private Investment (I)
Government Purchases (G)
Net Exports (X - M)
GDP = C + I + G +NX
Gross fixed capital formation (GFCF) is defined as the acquisition (including purchases of new or second-hand assets) and creation of assets by producers for their own use, minus disposals of produced fixed assets. The relevant assets relate to products that are intended for use in the production of other goods and services for a period of more than a year.
The term "produced assets" means that only those assets that come into existence as a result of a production process recognized in the national accounts are included.
This indicator is in million USD at current prices and PPPs, and in annual growth rates. All OECD countries compile their data according to the 2008 System of National Accounts (SNA).
Capital investment as percent of GDP
For that indicator, The World Bank provides data for the USA from 1960 to 2016. The average value for the USA during that period was 22.15 percent with a minimum of 17.51 percent in 2009 and a maximum of 25.08 percent in 1984.
The capital investment in the USA and other countries is calculated as the purchases of new plant and equipment by firms, as percent of GDP. A high number is good for long-term economic growth as current investment leads to greater future production.
Definition: Gross capital formation (formerly gross domestic investment) consists of outlays on additions to the fixed assets of the economy plus net changes in the level of inventories. Fixed assets include land improvements (fences, ditches, drains, and so on); plant, machinery, and equipment purchases; and the construction of roads, railways, and the like, including schools, offices, hospitals, private residential dwellings, and commercial and industrial buildings. Inventories are stocks of goods held by firms to meet temporary or unexpected fluctuations in production or sales, and "work in progress."
CapEX Kings: Which S&P 500 Cos. Spend the Most
Cash may is king, but when it comes to investing in stocks, companies with big capex budgets may do better than their more frugal peers.
That’s according to new research from Goldman Sachs in which the Wall Street firm looked at the impact capex has on free cash flow/a>. While lots of investors seek companies that have a ton of cash on hand, the investment firm said investors should favor those investing more in capital expenditures and research and development over those that aren’t. The reasons: those companies tend to be rewarded more in the stock market and don’t have to play catch-up like those that haven't been investing in future growth.
“A growing chorus of investors calls for companies to refocus attention on long-term investment in a stock market that has become fixated on share buybacks.
Our sector-neutral basket of the 50 stocks with the highest trailing 12-month total capex and R&D spending as a share of market cap has outperformed S&P 500 by 16 [percentage points] since the beginning of 2016,” wrote a team of analysts in a recent research report. “In comparison, our sector-neutral basket of stocks with the highest trailing 12-month buyback yields has underperformed S&P 500 by 4 [percentage points during the same period.”
Top Capex Spenders
Despite the importance of pouring money into capex and R&D, Goldman Sachs finds capital expenditures as a share of cash flow from operations has been falling since 2002.
From 1990 to 2002, S&P 500 companies spent on average 69%, but that dropped to 47% from 2002 to 2017. At the current 44% range, the Wall Street firm said the capex investment ratio ranks in the 5th historical percentile. But that doesn’t mean all companies are reining in their spending on capex and R&D.
Goldman has a list of stocks that see the importance of investing in future growth that could reward investors down the road. Many of them are in capital-intensive sectors like energy and transportation while others aren’t. With that in mind, here’s a look at the top five S&P 500 spenders when it comes to capex.
In first is General Motors Co. (GM), which Goldman notes that the car maker has a negative free cash flow yield because of high levels of capex—$29 billion last year. The analysts estimate it spent $40 billion on growth capex and $23 billion in R&D.
Coming in second is Chevron Corp. (CVX), the energy company, which spent $26 billion on growth capex so far this year and $2 billion on R&D, according to the report.
Rounding out the top three is Alphabet Inc. (GOOG), which through the end of July spent $20 billion on growth capex and $36 billion on R&D.
American Airlines Group Inc. (AAL), the airline operator with $16 billion in growth capex came in fourth place while
Devon Energy Corp. (DVN) and General Electric Co. (GE) were tied for fifth place with $15 billion earmarked for capex. Bradley Needham isn’t spending any money on R&D while GE is pouring $13 billion into future products and services, GS found.
The Bull Market Urgency Of Capex
That the tax reform bill which became law at the beginning of 2018 contains stimulus for the U.S. economy is not subject to dispute. Opponents of the bill politically still acknowledge that there is a stimulative effect from the bill, though the magnitude and sustainability of that stimulus is subject to a bandwidth of perspective. Most skeptics of the long term economic stimuli of the bill argue that its savings will result in shorter term actions that have limited multiplier effect (one-time bonuses to employees, share buybacks, dividends, debt reduction, etc.). To be clear, no action or potential action we can think of out of what companies do with the net savings afforded them from corporate tax reform can be considered “negative” – in fact, all offer varying degrees of benefit to shareholders, laborers, customers, and the economy at large.
The issue, rather, is where the multiplier effect will be most magnified – for the longest period of time. I should say, that is the issue if sustainable top-line economic growth of > 3% is the policy agenda. And this is why business investment is so vital to the success of tax reform, but more importantly, the expansion of this bull market.
We start with the obvious: Capex spending is on the rise!
It is crucial to remember that capital expenditures are “spending” for one company and revenue for another.
For the company who receives revenue, it is growth-capital, top-line sales, and the critical mass that drives their business. Profit growth comes from revenue growth. Unless a company’s model calls for negative profit margins, an increase in capex spending is an increase in revenues, as the companies who build the factories, widgets, and new technologies, or supply the software, hardware, or vehicles, see their business sales expand. But that only tells half the story, and in this case, it is anything but zero sum. What about the companies “spending” the money?
Is one company’s revenue just an expense to the other company, negating any profit creation opportunity in the macro? Quite the contrary! While there is a short term benefit to the company receiving the revenue, there is a long term benefit to the company spending the money. Indeed, that investment becomes the basis for future profit creation, as new factories, equipment, and technology set the table for business growth, improved efficiency, new markets, new products, and general innovation. Businesses that do not trust the sustainability of business conditions do not invest in their futures.
Capital expenditures do not merely drive growth and productivity; growth and productivity dry up without capital expenditures. Greater growth and productivity drives wage growth. Wage growth drives more consumption. More consumption drives more production. And the expanding profits from this whole virtuous cycle incent more of the same! Capex is the engine by which both short term and long term benefits are most realized in this cycle. The “supply side” potential of the tax reform comes to life where capex is effectuated.
When confidence or sentiment appears high, but capex spending remains low, it is a sign that things seem rosy in the short term, but an underlying belief in persistently robust conditions is low (often out of fear of government policies, excessive debt, interest rate vulnerability, etc.). The post-crisis recovery was impressive in short term conditions, but the noticeable lack of capital expenditures despite favorable borrowing conditions indicated a tepid confidence in the economic and corporate climate.
The early signs of reversal in this trend, and our forecast of a true renaissance in capital expenditures, are both a sign of better things to come, and the self-fulfilling prophecy thereof.
The mandate of the national economy is growth, both to counter-act malignant debt assumption, but also to create wage growth for the middle class. The only known impetus to growth is the pursuit of profits. With a renewed vigor for capex, we not only will achieve greater profits in the near term, but set the table for the needed profits into the long term that will drive the next inning of this bull market
With 4.1% U.S. GDP Growth, What Comes Next?
We are living in the second longest period of economic growth since World War II. If this recovery is sustained into 2019, it will be longer than run up to the dot-com boom.
While it is natural to assume that old age may soon take its toll, the current recovery has been extremely shallow. This suggests that excesses have not built as quickly as in other cycles and the current growth run still has some staying power. The U.S. economy is currently showing no signs of slowing. In the second quarter of this year, U.S. GDP growth hit an annualized 4.1%.
Until now, corporations have held off on capital expenditure. But confidence in the economy could lead to a renaissance, which might sustain the current market cycle for a few more years.
Cumulative Nominal GDP Growth Post-Recession
A Renaissance in Capex
Robust business investment has been missing from this current market cycle.
After the financial crisis, companies pulled back on capital expenditure, given existing spare capacity and a desire to rebuild balance sheets. Instead, they diverted excess cash flow to reward equity investors with dividends and buybacks.
As a consequence, corporate America’s equipment is now starting to look rickety, and capex could experience a cyclical upswing.
The Bureau of Economic Analysis estimates that America’s capital stock is the oldest on record, averaging 23 years. As companies grapple with aging equipment and hiring challenges, recent tax incentives that reward higher capex are encouraging companies to upgrade capital and improve automation.
A report from Credit Suisse, showed that in the first quarter of 2018 capital expenditure was up 24% over the fourth quarter of 2017. This was its fastest pace in six years. Half of this pick up was attributed to technology with the balance in consumer discretionary, energy, telecom and industrials.
In more recent data, the July Beige Book, which surveys 12 Federal Reserve Bank districts, highlighted an improving outlook for capital expenditures. A critical driver of that interest is concerns around labor shortages and the need to offset with capital investment.
Recent data from the Business Roundtable survey of U.S. CEOs also confirmed a bullish outlook for capital expenditures. The biggest risk that expectations don’t carry through to revitalization in capex is trade uncertainty. Both the Beige Book and Business Roundtable flagged tariff retaliations as a significant concern.
Are We Headed For A Downturn?
U.S. recessions are usually ignited by domestic malinvestment, geopolitical shocks or Fed tightening. But while there is plenty to worry about, the U.S. still looks like an economy that is reasonably robust.
Since the last financial crisis, households have been cautious on re-leveraging and, through a combination of constraints, new home construction has lagged.
Meanwhile, in a low interest rate environment, corporations have levered up to fund M&A, dividends and stock buybacks. But much of the M&A to date has been strategic, as opposed to a rush to dubiously increase size, which is more evident in late cycle behavior.
Geopolitical risk is rising as the U.S. turns protectionist. In particular, the trade standoff with China could escalate further, cascading into market disruption and weaker growth.
And given moderate inflation, the Fed has started tightening its fiscal policy. However, it is signaling it will proceed at a measured pace and remain data dependent.
Capex Growth Rate
An Extension to The Current Cycle
It would be unprecedented if the current business cycle ended without an upswing in capex. Over the last forty years, capex spending has typically lagged profit growth by one year. Robust profits embolden CEOs to make long-term commitments and increase competitiveness.
Ramping up spending on capex could have a material impact on productivity, as well as helping to mitigate the risks of overheating as labor shortages create bidding wars for talent.
This interaction of a tight labor market coupled with tax incentives to increase capex could bring another gear to growth.
We seem to be nearing a capex inflection point that could fortify the current expansion for a few more years.
Large Cap in China
Black Rock Chinese Large Cap ETF (FXI)
FXI: Is It Weighed Down By Chinese Reform?
iShares China Large-Cap ETF (FXI), Includes: ASHR, CXSE, KWEB
President Xi’s legacy will be defined by his success on state-owned enterprise reform and financial regulation overhaul.
This is bad news for holders of FXI; the firms (Large Cap) most affected make up the majority of the ETF’s components.
Concerns now voiced about two areas of China, both of which center around government-led reform:
- The Chinese government is pushing through its plans for state-owned enterprise reform, something aided by the removal of the two-term limit of Chinese presidency.
- Financial regulators are undergoing a massive multi-industry reform, bringing all firms under a single regulator and stamping out risky business lines.
Both of these will be positive in the long term as greater regulation and operational efficiency makes for a better market. However, the short-term cost of this is a firm-wide focus away from profitability in order to implement these government reforms.
These two risk factors will mostly affect Chinese financials and state-owned companies.
The BlackRock iShares China Large Cap ETF (FXI) is heavily exposed to these two types of firms.
We now believe that investors should reduce their exposure to FXI.
State-owned enterprise reform
This is relevant to FXI because over 70% of its holdings are in companies directly controlled by entities of the Chinese government. Over 70% of the ETF’s holdings will have to prioritize government-led operational efficiency reform instead of normal business operations. The likely result of this would be lower revenues and profits.
How investors should play China?
The optimal China position should be one that has long exposure to tech and e-commerce firms, as well as large-cap domestically-listed firms, while being short exposure to state-owned companies, particularly financials:
- Long: KWEB and ASHR
- Short: FXI
- Net exposure: Long
Given the performance of the three ETFs, particularly over the past few months, I believe that KWEB has been oversold and ASHR is set to benefit greatly from A-share inclusion. KWEB is more short term, while the financial and state-owned reform affecting FXI is a process that could last for a decade.
One alternative to this structure would be to take long positions in KWEB and in WisdomTree’s China ex. State-Owned Enterprise ETF (CXSE), which would offer exposure to large companies likely to be included in FTSE Russell’s broad indices, while having no exposure to companies undergoing government-led reform.
It is clear that CAPEX is an important factor in a countries growth trajectory (GNP) and can greatly influence investors’ returns
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